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n an effort to combat inflationary pressure, Bank Indonesia is implementing new IDR minimum reserve requirements, instead of raising the BI rate, which the central bank believes could trigger more foreign funds flow and further strengthen the local currency.

At the same time, LDR-linked reserve requirements are expected to boost loan growth, helping to ensure that the Indonesian economy will continue to grow going forward.

Unless inflation runs out of control, we believe that the expected increase in BI rate in fourth quarter of this year would be delayed until next year. It is worth of noting that August’s inflation reached 0.76 percent month-on-month, bringing year-to-date inflation to 4.82 percent or 6.44 percent year-on-year.

The recently endorsed reserve requirement are split into two parts with the first part being higher primary reserve requirement to 8.0 percent, effective beginning November 2010 from 5.0 percent previously, while maintaining secondary reserve (i.e., BI certificates, treasury bonds and etc) at 2.5 percent. This additional 3.0 percent reserve requirement, more than Rp 60 trillion in liquidity absorption, would earn 2.5 percent interest per annum at Bank Indonesia. The increase would apply to all banks and, consequently, lead to higher funding costs and lower earnings.

The second part of the reserve requirement ruling, effective on March 1, 2011, refers to additional reserves linked to each individual bank’s LDRs, encouraging banks with excess liquidity to lend more aggressively. Banks would be required to top up additional 0.1 percent for every one percent LDR below 78 percent, based on the formula of 0.1 x (78 percent - LDR<78 percent). Big banks that fall into this category include Bank Central Asia (LDR of 51 percent at end 1H10), Bank Mandiri (64 percent) and Bank Negara Indonesia (68 percent).

However, we believe the aforementioned government plan to get banks with excess liquidity to lend more aggressively using this LDR linked reserve requirement will not materialize as some banks have become more cautious and vigilant in anticipating further liquidity tightening ahead. Moreover, recent statistics indicate that the industry’s average LDR had reached 78.1 percent at end July 2010, increasing from 75.8 percent a year earlier.

In contrast, banks with LDR above 100 percent and Capital Adequacy Ratio (CAR) below 14 percent would be extensively penalized by doubling reserve requirement, from those banks with LDR of below 78 percent, based on the formula of 0.2 x (LDR>100 percent – 100 percent). This higher reserve requirement would prevent a financial collapse without impeding fragile economic recovery.

Amid higher funding costs for banks with low LDRs on the back of this new 78/100 Reserve Requirements, we recommend investors to be in banks with strong deposit franchise, which would allow continued strong liquidity to lend under this tighter monetary condition. Ironically, the above-mentioned three banks (Bank Central Asia, Bank Mandiri and Bank Negara Indonesia) are banks with strong deposit franchise, making them the main beneficiaries of this new higher reserve requirement.

We believe that Bank Indonesia attempts to foster economic growth while concurrently keeping inflation in check. This will be difficult to accomplish in our view. At the end of the day, the burden falls on big banks with excess liquidity which is being encouraged by the central bank to continue channeling their loans in the vicinity of between 15-20 percent per annum to support economic growth while Indonesia is gradually entering a tighter monetary policy.

The writer is vice president/deputy head of research at PT Bahana Securities.